It’s easy to buy shares of a company if you think their value will rise. But what do you do if you think a company is overvalued and the shares are likely to fall?
Short selling is the process of betting against stocks to profit when they lose value. In this guide, we’ll explain how short selling works, how to short stocks, and what you need to consider when betting against a company.
What is Short Selling?
Short selling, or shorting, a stock entails betting against a company so that you profit when the stock loses value. It’s essentially the opposite of buying a stock, in which case you’re betting that the price of the shares will rise.
You might sell a stock short if you think it is overvalued and the market has not yet self-corrected. Or, you might short a company if you spot a competitor or trend that represents a threat to that company’s business.
How Does Short Selling Work?
When you short sell a stock, your broker lends you the shares you want to short. You then immediately sell those borrowed shares at the current market price.
Then when the share price falls, you can buy back the stock and return the shares you borrowed to your broker. The difference between what you sold the shares for at the start of your trade and what you bought them back for is your profit.
How to Short Stocks
The mechanics behind shorting a stock may be more complicated than buying a stock, but most brokers make initiating a short trade just as easy. Just look for the option to ‘Sell’ or ‘Short’ in your broker’s order form instead of clicking the default ‘Buy’ button.
You can also short stocks using put options. These give you the right to sell a stock at an agreed-upon price up until the option contract’s expiration date. So, if you think Apple shares will fall, you might by a put option that gives you the option to sell Apple stock at the current price. If the stock does fall, you can buy the shares cheaply and then sell them above market value by exercising your put option.
Factors to Consider When Short Selling
Shorting a stock may be as simple as buying a stock through your broker, but there are important differences between the two types of trading. It’s important to be aware that short selling comes with an entirely different set of rules and risks than buying stocks.
First, it’s important to understand that you face unlimited risk when short selling stocks. This is fundamentally different from your risk when you buy stocks, which is limited to the amount you invested in the shares.
If you’re wrong about a stock being overvalued and the price keeps rising, there’s no limit to how high it can go. No matter how high the price gets, though, you’re still responsible for buying back the borrowed shares and returning them to your broker. So, you could lose a lot more than just the amount you invested in the short sale in the first place.
If the stock price starts to rise after you enter a short position, you could face a margin call from your broker. This is essentially a notice that you need to either close some or all of your short position or deposit more money into your account.
Margin calls happen because most brokers require that you keep a certain amount of cash in your account to repay your borrowed shares. This money, known as margin, is essentially collateral for the shares you borrowed – you (or your broker) can use it to repurchase the shares from the stock market and at least partially close your position.
The amount of cash you need to keep as margin is typically a fraction of the value of the shares you need to repurchase. So, as the share price rises and the trade moves against you, the amount of margin you need to have rises as well. If you fall below the required margin, your broker will send you a margin call.
Margin calls are problematic because you either need to close out some or all of your position for a loss, or deposit more money into your account. If you decide to deposit more money to keep your trade open, those funds are now at risk as well.
When you short a stock, you may have to pay an interest or borrowing fee. This is because most short sales involve borrowing money from your broker.
Say, for example, you open a $1,000 short position. You might put up $200 of your money to open the short, but your broker will loan you $800 for the remainder of the position. In that case, you’ll need to pay an interest rate of several percent on the $800 you borrowed. The interest rate will be charged daily or monthly until your position is closed.
If you want to short a stock that’s considered ‘hard to borrow’ – that is, shares that are in short supply or high demand – most brokers charge a higher interest rate.
An important thing to consider is that in order to short a stock, your broker must have shares of that stock available for you to borrow. However, many commission-free brokers like Robinhood, Webull, and others typically only have a small inventory of stocks that are available for shorting. They may limit not only what stocks you can short, but how many shares you can borrow for your short position.
Traditional brokers typically have a larger inventory, especially for stocks on the NYSE or NASDAQ exchanges. If you want to short companies that aren’t frequently traded, though, you’ll need to find a brokerage that specializes in short selling.
Short selling offers a way to profit when stocks fall in value, and it can be a good strategy if you think a company is overvalued. Most brokers offer shorting, although the selection of shares to borrow and the cost of borrowing can vary widely.
Keep in mind that short selling comes with additional risks. There’s no limit to how much money you can lose when shorting stocks, and you may be forced to liquidate your position early if a trade goes against you.